Slapped By The Invisible Hand

I read Gary Gorton’s Slapped By the Invisible Hand: The Panic of 2007 last night. I think it’s must-reading for anyone who wants to understand the recent economic unpleasantness. The best way to think about the book, I think, is that rather than trying to explain “what caused the crisis” in the sense of the bubble and subsequent crash, he’s trying to explain what made the crisis so crisis-y. Why were the consequences so dire, in other words.

To sum up, his point is that panics—bank runs—were long endemic to American banking. The banks themselves were pretty innovative at trying to concoct private sector schemes to mitigate panics, but they never got rid of them and they were always bad. Then came the Great Depression and the biggest banking collapse ever. This led to deposit insurance—which he emphasizes was a very controversial idea at the time—and decades of banking peace. Then as part of the general deregulatory trend starting in the late-seventies we undertook a lot of measures to de-cartelize American banking. This exposed depository institutions to more competition and led to better deals for consumers, but also made the traditional regulatory banking system less profitable than it had been.

That provided an impetus for the growth of the “shadow” banking system where there was more money to be made. But having essentially re-created old-school non-insured banking, we once again left ourselves vulnerable to bank panics and bank runs once the decline in housing prices revealed the fact that not all the high-rated securitized loan products were really worth as much as advertised. This led, just like the bank panics of yore, to a collapse in the money multiplier operating in the shadow system and a huge liquidity crunch. But the existence of the bank runs has been largely hidden from the view of normal people, since normal people—including journalists, members of congress, academic economists—don’t use the shadow system, it’s a place for fairly large firms to park funds and not normally something people interact with.

Daniel Davies objects that there have actually been a bunch of crises since 1970. But I think Gorton would reply that these crashes didn’t have the specific character of bank runs where suddenly people or firms can’t conduct transactions.